If you need a sense of how the retail real estate market has changed over the past 12 months, all you have to do is take a close look at a deal that Faris Lee Investments, an Irvine, Calif.-based retail investment brokerage firm, closed this fall. The sale involved a recently completed project in Corona, Calif. The center is anchored by a Van’s supermarket, but most of the shop space has never been filled. The center is located in a growth area, and Rich Walter, president of Faris Lee, estimates that it will likely take from two to three years to lease the vacant shops. Yet the buyer was happy enough to get a property with a grocery anchor to close the deal at a 6.5 percent cap rate on the current income stream.

“It’s a risky transaction because you are trying to forecast when the rental market will come back in a market where you don’t see it,” Walter says. “It’s not that it’s not going to be leased at some point. The question is when. But they are happy enough with the return to be willing to sit on it over time.”

Back in 2009, this kind of logic would be unfathomable to most industry insiders. But as a result of the record low interest rates and increasing liquidity in the market, real estate investors can suddenly afford to gamble. When debt is priced at 5 percent, it’s possible to accept cap rates in the 6 percent to 7 percent range, notes Dan E. Gorczycki, managing director in the New York City office of Savills LLC, a real estate services provider.

Granted, in 2010, most investors have been trying to play it safe by chasing grocery-anchored strips in primary markets like New York, Washington, D.C. and San Francisco. But the supply of those centers is limited and the capital that has been amassed in the past few years has to be deployed. Low interest rates are adding fuel to the fire. That’s why in 2011, investment sales brokers expect an increased level of activity on class-B and some class-C assets.

Investors the world over are looking for yield and commercial real estate presents an attractive opportunity. Rents and occupancies have been stabilizing and showing signs of improvement, albeit slowly, making retail properties more attractive as acquisition targets. The credit markets have also loosened up over the past 12 months, making it easier to finance transactions. And with cap rates either flat or trending down, sellers that were previously reluctant to bring properties to market are beginning to jump into action.

“The availability of funds will cause the market to have more transactions,” says Walter. “Financing availability has caused cap rates to compress on the core properties. The cash on cash return is better and people can get into properties without having to pay a lot of cash. In 2011, this will eventually drift down to lesser quality assets.”

Dan Fasulo, managing director and head of global research with Real Capital Analytics (RCA), a New York City-based research firm, forecasts that next year retail investment sales volume will reach anywhere between $30 and $40 billion, a level of activity last seen in 2004. It would be double the total projected retail sales activity in 2010, which Fasulo thinks will end up coming in at between $18 billion and $20 billion.

“The market is changing very rapidly,” Fasulo notes. “The lack of supply is really encouraging more and more healthy owners to put properties [up] for sale.… Prices may continue to bounce along the bottom in certain markets, but they will continue to escalate in the primary markets and the top tier secondary markets.”

In other words, the sector might return to a normal level of activity sooner than most investors had anticipated.

Where we are

Fundamentals in the retail sector have gotten better throughout 2010. Leasing indicators finally began to improve in the third quarter, which marked the first time since 2007 that vacancy rates either remained flat or declined. At the end of third quarter, the vacancy rate for community and neighborhood shopping centers stood at 10.9 percent, the same as the quarter prior, according to Reis Inc., a New York City-based research firm. The vacancy rate for regional malls fell 20 basis points, to 8.8 percent.

There are still some concerns that vacancies may rise during the first six months of 2011 before finding firmer footing. But with limited amount of new space in the pipeline, if consumer spending remains stable, retail vacancies should continue to shrink, says Chris Macke, senior real estate strategist with the CoStar Group, a Bethesda, Md.-based research firm.

At any rate, even the appearance of improving leasing fundamentals serves to calm investors’ fears. There is a feeling in the marketplace that the retailers that escaped the Great Recession are, as a group, in better financial shape than they were pre-2007, says Alan L. Pontius, senior vice president and head of the national retail group with Marcus & Millichap Real Estate Investment Services. And the lack of new development is an added bonus, according to Christopher J. Decoufle, Atlanta-based senior vice president, capital markets, with CB Richard Ellis’ national retail investment group.

“The fact that there is no new competition is very important for anyone on the acquisition side because it removes a lot of ambiguity from your underwriting,” Decoufle notes.

At the same time as the leasing outlook began to improve, the third quarter of 2010 marked a turning point for investment sales activity. The quarter was the strongest for investment sales since the downturn began in the fall of 2007, according to RCA. Retail volume reached $5.5 billion, an increase of 131 percent over the same quarter a year ago and almost double the figure recorded in the second quarter.

Year-to-date, retail investment sales volume has totaled $13.4 billion, overtaking the $13 billion recorded in all of 2009, according to Fasulo. A lot of the activity is currently focused on grocery-anchored shopping centers in primary markets. In fact, cap rates for such properties have registered a 115 basis point drop from the third quarter of last year, to 7.8 percent.

But with everyone “tripping over themselves” to get to the core product, there might be limited opportunity left in that space, says David J. Lynn, managing director with ING Clarion Partners and author of “Emerging Market Real Estate Investment.” Today, every class-A deal gets 20 to 30 offers, notes Rich Walter, and every month these deals close at a lower cap rate than the month before.

“Everybody always says ‘Never again will I pursue B and C assets,’” says Lynn. “But the competition is so great I think it’s inevitable that in search of yield the money will go to secondary and even tertiary markets. But I think it will still be about income, durability and quality assets that have rooftops around them. Vacancy in secondary and tertiary markets will still be viewed as a very bad thing.”

Liquid gold

Part of the reason grocery anchors have been in demand this year is because they are necessity-based and perform well regardless of the economic environment. It’s also easier to line up financing for grocery-anchored centers, notes Decoufle. Today, virtually any lender, including banks, life insurance companies and conduit lenders will provide loans for grocery-anchored strips in primary markets. With a loan-to-value (LTV) ratio under 60 percent, the interest rates on such properties can start at 4 percent on five-year fixed-rate loans.

On some assets, it’s even become possible to get interest-only loans, says Matthew Donnelly, senior vice president of structured finance with Cole Real Estate Investments, a Phoenix, Ariz.-based real estate investment and management firm. In recent months, Cole has been able to secure 10-year, 4 percent, fixed-rate, interest-only financing on well-leased, multi-tenant centers with anchors like Walmart. This has been partially due to the quality of the assets, but also Cole’s conservative LTV ratios—the firm normally keeps leverage down at 50 percent, Donnelly says.

In 2010, Cole has been among the most active investors in U.S. retail properties. By the end of the year, the company plans to close at least $2.5 billion in acquisitions, with a strong focus on power centers, grocery-anchored centers and single-tenant net-leased properties. In contrast, last year, Cole purchased $900 million in assets.

But while there is plenty of liquidity available for the kinds of acquisitions Cole targets, unanchored strip centers and class-B malls remain virtually un-financeable, according to Gorczycki. Today, financing that kind of property requires putting in additional equity or taking on mezzanine debt. Choosing to add more debt could result in a blended interest rate ending up near 8 percent.

Next year, however, the recovery will be further propelled by the reappearance of CMBS lending. As of October, U.S. CMBS issuance totaled $11.6 billion, according to Commercial Mortgage Alert, an industry newsletter. Next year, that figure might double, says Pontius.

What’s been significant about the more recent CMBS pools is that they have included some less than stellar assets, notes Gorczycki. By the end of the year, CBRE’s national retail investment group hopes to close a conduit loan on a portfolio of class-C+ centers, says Decoufle. Meanwhile, the largest loan in the $856.6 million issue currently being put together by Deutsche Bank is on the Fashion Outlets of Niagara Falls, a 525,663-square-foot outlet center in Buffalo, N.Y.

Outlet centers have been outperforming most other retail properties recently, but Buffalo can hardly be considered a top tier market, Gorczycki points out. In search of returns, the conduit lenders have been trying to throw in the lesser quality properties with the class-A ones. They have started putting together multi-borrower deals with a greater variety of assets. In the first half of 2010, CMBS lenders stuck to single-borrower issues and concentrated on only the most stable properties.

Learning to deal

The improvement in market conditions might also create an incentive for lenders to finally get rid of some of the distressed debt on their books. For most of 2009, lenders opted to “extend and pretend.” In 2010, they began to deal with distressed properties more actively—in the second and third quarters, 13 percent of all retail transactions involved distressed centers, according to RCA. In the third quarter, approximately $200 million in assets were removed from the pool of distressed retail real estate. Many of those properties have been put on auction and sold for all cash, brokers say.

In 2011, lenders will still be holding on to quality centers with good credit borrowers in the expectation that the valuation on those assets will continue to improve, notes Gorczycki. But after shoring up their balance sheets in 2010, they will likely begin to get rid of everything under $20 million.

“Just from the administrative standpoint, lenders are overwhelmed, so you’ll see a lot of small deals come to market,” Gorczycki notes. “And at the beginning, there will be no shortage of buyers. But at some point, there will be some product that doesn’t sell and it could have a chain reaction.”

Money makes the world go round

It’s important to note that the recent recovery in the investment sales market might have less to do with the improvement in fundamentals than with the global hunger for yield, says Fasulo. In the third quarter of 2010, 19 private equity funds worldwide raised a total of $8.8 billion for real estate acquisitions, according to Preqin, a London-based research provider on the alternative assets industry. The figure represents a 20 percent increase over the second quarter. Year-to-date, the total figure for private equity funds raised for real estate acquisitions comes to $25.9 billion.

In addition to private equity players, public and private REITs, life insurance companies, pension funds and foreign buyers have all been allocating more money to real estate acquisitions in recent months, Fasulo notes. For example, U.S.-based REITs will likely complete $16 billion in acquisitions by the end of the year, representing a 300 percent increase from the $4 billion in transactions recorded in 2009, according to a recent report from KeyBanc Capital Markets Inc.

Meanwhile, ING Clarion projects that in 2010 pension funds and other large institutions will invest a total of $34 billion in U.S. private equity real estate funds and direct real estate acquisitions, up from $18 billion in 2009. (The figure excludes investments in real estate debt and in REITs). Approximately $12.5 billion of that will be allocated for core product. But another $6 billion will go toward value-added properties, with $7 billion and $8.8 billion, respectively, allocated for opportunistic investments and “other.”

If this trend continues unabated through next year, it will become easier to secure financing for class-B and some class-C product, says Decoufle. That will likely cause an uptick in pricing for those centers and push owners that have been reluctant to sell at huge discounts to finally close some deals.

Year-to-date in 2010, Decoufle’s group had closed $500 million in deals, representing a tenfold increase over the same period in 2009. In 2011, he expects transaction volume to “easily” increase by 25 percent.

On the national stage, Pontius projects that transaction count will also increase by about 25 percent next year. And the increase in dollar volume will be even greater—anywhere from 30 percent to 35 percent.

“This is a classic, cyclical pattern and we are all reverting to that pattern,” Pontius says. “The capital has come back in and the stability has returned.”